Thursday, October 28, 2004

A few weeks ago I apologized that because of a lack of time and the proliferation of anti-spam software, the FinanceProfessor.com newsletter was not really working as I had hoped. Thus, I offered my view that the blog was the future. Not surprisingly, I had a few complaints from those who liked the newsletter format better.

However, I also got a few subscribers saying that they would like more news (instead of reviewing academic articles. To this I would say that there are so many good sites out there, I am not sure what value I can add. Specifically, I suggest the NY Times Deal Book which is how I start most days. Sign up for it!! It is free and HIGHLY RECOMMENDED!

That said, I know many of you are also interested in accounting stories, so I would like to suggest the Financial Accounting Blog and the newsletter from AccountingWEB.com. Both are very informative and interesting! I read the blog through my MYYahoo page and have subscribed to the AccountingWEB weekly newsletter!

BTW, no I do not get anything for these plugs, I am just trying to help! And to lessen the complaint letters that I get! ;)

For about as long as I can remember (which some days is a few hours ;) ) I have wondered what would happen when the so-called baby boom generation retires and starts withdrawing money from the stock market. Will they depress the stock market? Should I save more as a result?

Geanakoplos, Magill, and Quinzii provide an interesting look at this question and their findings suggest that those of us behind the baby boomers had better plan on saving more than we would otherwise and assuming lower returns in all future value calculations.

A few highlights from the paper:

"Agents have distinct financial needs at different periods of their life, typically borrowing when young, investing for retirement when middle-aged and disinvesting in retirement. The stock market (along with other assets like real estate and bonds) is a vehicle for the savings of agents preparing for their retirement. It seems plausible that a large middle-aged cohort seeking to save for their retirement will push up the prices of these securities, while prices will be depressed in periods where the middle-aged cohort is small. "

Which translated to a language that my classes would better understand is that when there are fewer surplus spending units (SSU), the market will fall.

Interestingly the authors show that this price cycle could occur even if market participants were aware of the changing demographics (I confess that I am not sold on this part of the paper).

"Poterba (2001) has argued that if agents were rational, they would anticipate
any demography-induced rise in stock prices twenty years earlier, bidding up the
prices at that time, thereby negating much of the demographic effect on stock
prices. We show that if agents were myopic, blindly plowing savings into stocks
when middle-aged, then stock prices would be proportional to the size of the
middle-aged cohort. When agents fully anticipate demographic trends, their
rational response actually reinforces the effect on stock prices, making its
rise more than proportional to the size of the middle-aged cohort."

Which means that when baby boomers retire, we should expect stock prices to fall.

In investigating this relation, the authors also improve our understanding of the equity risk premium (the measure of returns greater than the risk free rate of return). In their words:

"Previous work has suggested that the equity premium observed historically is
difficult to reconcile with a rational expectations model on two counts. First,
the historical equity premium is too large to be rationalized by reasonable
levels of risk aversion (Mehra and Prescott (1985)). Second, and most important
for us, the observation that young people are more risk tolerant than old
people (Bakshi and Chen (1994)) suggests that the equity premium should be
lowest when the proportion of young people is highest, exactly contrary to
the historical record."

"Our stochastic model sheds some light on the second problem. If there is a
strong demographic effect, then the numerous young (and contemporaneous few
middle aged) should rationally anticipate that investment returns will be
relatively high. Since wages and dividends do not vary so dramatically with
demographic shifts, they should anticipate that a relatively high fraction of
their future wealth will come from risky equity capital values. Though
the average risk tolerance is higher, the average exposure to risk is also
higher, and so we find that in our model the equity premium is higher when the
stock market is low, consistent with the historical record."

Get that? It means that because of the greater TOTAL exposure, the effective equity risk premium is greater for young investors. Thus, when young investors are more numerous (and consequentally the market prices are low since there are relatively fewer middle-aged investors, the equity risk premium should be HIGHER! Which fits the evidence and helps to explain why risk premiums were low during much of the 1990s.

Wednesday, October 27, 2004

Shout, shout let it all out! Sorry about the cheesy Tears for Fears referencee, but the quiet period may be over for large firms! The SEC has requested comments on ending the quiet period. And to that I say HURRAY!

The so-called quiet period was the time when firms that were in the process of selling shares to the public could not communicate with the public. This led to many problems when managers spoke (either intentionally or not) to the public. Most recently the notorious Google Playboy interview.

But finally the SEC has come to its senses and wants to relax the quiet period restrictions:
From CNN/Moneyline:

Companies selling stock to the American public would be allowed to talk
much more freely about it, and even advertise, under a proposal given
preliminary approval Tuesday by federal regulators.

In an effort to overhaul rules from the 1930s, the Securities and
Exchange Commission voted 5-0 to propose largely eliminating the so-called
"quiet period" preceding stock offerings for very large companies.

and it gets even better!

Television advertising of offerings could follow, while media interviews with executives of companies selling stock would be clearly allowed under the proposal, officials said....Balancing these new freedoms would be strict rules about legal liability for major misstatements or omissions of important facts in interviews, ads or other communications outside the traditional SEC filing regime.

The old rules still apply to small firms, but this is a step in the right direction!

Currently, in many countries firms are allowed to advertise prior to the IPO and there is no quiet period. So there should be a large sample to study to see what impact this will have on raising new capital.

BTW it should be noted, that even in the US firms did try to find ways around the old rules. For instance, you were allowed to advertise for your firm's products. Thus, Chemmanur and Yan find firms increase advertising during this opposed quiet period. So, starting in 2006, a new research idea: does advertising NOT increase during increase as much during the IPO process.

FTR Bonus points to those of you who also recognized the irony in the title of this post. It seems that I am also talking about the recent period where I have sort of been out of contact. A brief illness, a busy schedule, family demands, and travel conspired to keep me off line for a while, but hopefully I will be more consistent with my postings and updates!

In a controversial ruling, the SEC decided by a 3-2 vote to begin regulating hedge funds.

Prior to this, hedge funds have been largely unregulated. Since the funds are targeted at wealthy investors and institutions, it has been widely held that the SEC need not worry itself with the funds. However, as the classic Bob Dylan song says, “The times they are a changing.”

The arguments against regulation:

The basic argument against regulation is that the investors in the funds are wealthy and know what they are doing and do not need hand-holding. For instance the LA Times reports:
“Federal Reserve Chairman Alan Greenspan, Treasury Secretary John W. Snow and some members of Congress have argued that oversight isn't necessary for an industry catering to an elite clientele well aware of any risks.”

Interestingly, travel and circumstance have led me to speak with several hedge fund executives in the past month and from their perspective regulation is not only unnecessary, but also detrimental to both returns (costs have to be borne by someone) and risks as investors will now have less incentive to monitor the funds.

So why the registration now after years of nothing? There are several explanations:

Hedge funds have grown significantly (up nearly three-fold in the past five years by some estimates) and this growth may have broader implications for market stability (this is sort of the Long Term Capital Management explanation—where regulators fear that the collapse of a hedge fund could lead to market-wide price declines.
http://www.hedgeco.net/news_story.php?id=2799&flag=2
http://www.reuters.com/advisorToolkit/newsArticle.jhtml?type=fundsNews&storyID=6619207.

The lack of disclosure opens the door for potential fraud. From the SEC: Commission's inability to examine hedge fund advisers makes it difficult to uncover fraud and other misconduct. The Commission typically is able to take action with respect to fraud and other misconduct only after it receives relevant information from third parties, and frequently only after significant losses have occurred.”
http://www.sec.gov/news/extra/hedgestudyfacts.htm

It should be noted that the SEC rule itself is not overtly onerous; many fear that it is a first step in the door for regulators.

“Under the new SEC rule, hedge funds must register their names, addresses and
other information with the agency, including detailing the value of their
assets. Regulators will be able to review the funds' books….The new
requirements, scheduled to take effect in February 2006, will apply to hedge
funds with at least $25 million in assets and 15 U.S. clients.”

My guess is that it will not be as bad as those in the industry fear. Sure their costs will increase slightly, but they will also get increased exposure and it may be easier to get investors (although of late that has not been a problem for most hedge funds).

* As an aside, if you are looking for employment in the hedge fund industry, compliance may be a way to get a job.

PBS even provides teaching notes but they seem more suited for high school. One tip that I would suggest is to compare and contrast Fed actions following the crash of 1987 (and the attacks of 9-11 for that matter) and what happened after the 1929 crash.

PBS' timeline is also interesting. It shows much of the history that is inherently tied to the current marketplace. Related to this idea, I recently purchased Wall Street: a history from its beginnings to the fall of Enron of Wall Street. I am only about 25 pages in to it, but so far so good. It is always useful to see how "big" events influence history. For example, the 1929 crash led to the strengthening of the Fed and the creation of the SEC.

Monday, October 18, 2004

Research in behavioral corporate finance takes two distinct approaches. The first emphasizes that investors are less than fully rational. It views managerial financing and investment decisions as rational responses to securities market mispricing.

The second approach emphasizes that managers are less than fully rational. It studies the effect of nonstandard preferences and judgmental biases on managerial decisions. This survey reviews the theory, empirical challenges, and current evidence pertaining to each approach. Overall, the behavioral approaches help to explain a number of important financing and investment patterns. The survey closes with a list of open questions.

Still not convinced that you should read the paper? How about this quote:

"...when the primary source of irrationality is on the investor side, long-term value maximization and economic efficiency requires insulating managers from short-term share price pressures. Managers need to be insulated to achieve the flexibility necessary to make decisions that may be unpopular in the marketplace. This may imply benefits from internal capital markets, barriers to takeovers, and so forth. On the other hand, if the main source of irrationality is on the managerial side, efficiency requires reducing discretion and obligating managers to respond to market price signals.

The stark contrast between the normative implications of these two approaches to behavioral corporate finance is one reason why the area is fascinating, and why more work in the area is needed.

Very interesting! This is going to "appear in the Handbook in Corporate Finance: Empirical Corporate Finance, which is edited by Espen Eckbo."

sometimes I hate technology! I have rewritten this three times now. It keeps disappearing.

WOW! If you have not read today's WSJ piece on Market Efficiency be sure to do so! It is on the first page (far left hand column) by Jon Hilsenrath. It is worth making a trip out to buy the paper if you do

Short version:

Even Fama is now admitting that behavioral finance has its place in the field.

As a rule I will not link to material you have to pay for, but this is so good I had to!

Monday, October 11, 2004

Congratulations to Finn Kydland and Edward Prescott on winning the 2004 Nobel Prize for Economics!

While economic forecasting is difficult, our understanding has improved greatly in recent decades. We have come to understand that monetary and fiscal policy are important and that the supply side (not just the demand side) must be considered. These insights are in no small part because of Kydland and Prescott.

In any Macro Economics class or Money and Banking class it is now standard fare that supply shocks matter. For instance, the economy soared in the 1990s in part because of the increased technology that was available. Kydland and Prescott were at the forefront of this economic revelation when in 1982 "they created a model which showed that supply-side shocks -- such as technology -- are a driving force behind the business cycle, rather than variations in demand alone." (CNN)
Their famous 1982 Econometrica paper also showed the importance of expectations on the business cycle. For instance, if higher inflation is expected, but not here yet, market participant's will act as if it is there. This was particularly important during the 1970s when central bankers continually changed their policies designed to keep the inflation in check. Predictably, these changes often led to higher inflation. From the San Francisco Chronicle:

"In the 1970s, many Western countries had high inflation because their central
banks didn't keep a consistent monetary policy. They accepted rising inflation
for a short-term decrease in unemployment, said Per Krusell, a member of the
Nobel Committee for Economics. A 1977 article by Prescott and Kydland
highlighted this problem, which led to many countries forcing their central
banks to stick to certain policies, regardless of market forces."

Kydland teaches at Carnegie Mellon University and the University of California. According to the SF Chronicle he was teaching when he herd he had won:

"Kydland told The Associated Press he learned about the prize during a lecture
at the Norwegian School of Economics and Business Administration in Bergen,
Norway. "I was a little perturbed when they interrupted my lecture until I got
to the secretary's office and found out what the phone call was about,"

Prescott teaches at Arizona State. No reports as to what he was doing when he heard.

Overall a very good choice! FWIW I still think Jensen and Fama are deserving of the award. Maybe next year!

Thursday, October 07, 2004

Quick what is the only thing that economists can agree on? Free Trade! That said, many in the "public at large" do not agree. That is why it always serves us well to go back and see why free trade is a "good thing."

Ferguson begins off by explaining that many factors influence the economy, but his talk would focus on free trade. This focus is largely because in recent years there has been a split between economists and "the public at large" over free trade.

From a longer time perspective free trade is increasing:

"In the past half-century, global trade has become freer and has expanded rapidly. The ratio of trade (exports plus imports) to worldwide gross domestic product rose from only 16 percent in 1960 to 40 percent by 2001. In 1960, the United States, Germany, and Japan had average tariff rates of around 7 percent; these rates were more than halved by 1993."

Although most economists welcome these trends, the public at large has been much more ambivalent about international trade. Attitudes toward free trade in principle remain generally positive, but a substantial--and, perhaps, growing--minority of Americans hold more negative views."

Ferguson goes on to list benefits of free trade:

"International trade allows us to choose from a wider array of goods than would otherwise be available." This he estimates to be worth approximately 3% of GDP.

"A second benefit of international trade is its role in reducing the cost of goods and hence in raising our standard of living" While acknowledging the difficulty in valuaing this benefit of this cost reduction, he cites examples of products that enjoy the benefits of protection and shows that these goods have not fallen in price as much as goods and services that are subject to competition.

A "third key benefit of free trade is that it allows economies to specialize in the activities they do best. This notion was at the core of the classical economists' defense of free trade."

"In addition to promoting specialization, trade boosts productivity through a fourth channel of influence: opening the economy to heightened competition. This effect could occur either as firms are spurred by foreign competitors to become more efficient, or as the least productive firms are forced to close, thus raising the average level of productivity for the economy as a whole."

Ferguson also lists "Arguments agsinst Free Trade"

Trade has "given rise to large trade and current account deficits."

Trade leads to lost jobs. Here Ferguson gives several variants of the basic theme that free trade costs jobs. The key point: "Import competition clearly has cost some American workers their jobs and has caused them considerable hardship as a result. However, economywide equilibrating forces, including monetary policy, ensure that over time such employment losses are offset by gains elsewhere in the economy, so that the nationwide unemployment rate averages around its equilibrium level. In fact, the inflow of foreign capital that finances our trade deficit provides the funding for investment projects that employ U.S. workers." While the number of people losing their jobs as a result of international trade is relatively small, "We cannot and should not minimize the hardships of workers displaced by imports."

Many believe that "discuss is that import competition, whether or not it affects the number of jobs, shifts the employment mix from high-quality jobs to low-quality jobs.... However, no conclusive evidence has shown that, over the long haul, the service jobs being created pay less or are otherwise less desirable than manufactured jobs being displaced. Moreover, the declining share of manufacturing in U.S. employment most likely stems less from import competition than it does from the rapid pace of productivity growth in manufacturing; this growth outpaced the productivity "

Yeah yeah, but what about outsourcing? Again he answers this:

“There are no conclusive data, but a prominent study puts the number of jobs displaced through services outsourcing over the next decade or so at fewer than 300,000 annually, or less than 2 percent of the 15 million in total gross job losses I noted earlier. Moreover, only a fraction of those jobs represent high-skilled, high-wage jobs; these numbers are quite difficult to pin down, but one study puts the number of software jobs lost to India since 2000 at fewer than 50,000 annually.”

A problem with convincing many of the benefits of free trade is that the benefits are often hidden whereas the costs are often more readily seen. For example, we can easily see that a local plant has been closed and jobs shifted overseas, but we do not realize that we are paying less for cars etc because of free trade. Or your job just got outsourced and you do not care about how many millions of jobs are NOT outsourced.

To combat this, Ferguson suggests free trade advocates turn this around and showing how the absence of free trade (i.e. protectionism) can hurt.This is easier to quantify:

"Rather than arguing the merits of international trade in the abstract, advocates of free trade might gain more traction by arguing against concrete examples of protectionism"

Case in point, the steel tariffs of the US that were imposed to protect steel makers. Not only did they not work, they probably ended up costing more jobs (even in the US)!

"...by raising the cost of goods that are inputs for other producers, import barriers may destroy more jobs in so-called "downstream" sectors than they save in protected sectors. According to one study, the 2002 steel safeguard program contributed to higher steel prices that eliminated about 200,000 jobs in steel-using industries, whereas only 187,500 workers were employed by U.S. steel-producers in December 2002."

Moreover, protectionism designed as quatas can actually serve to help foreign producers by allowing them to sell at a higher price AND to be compensated (through WTO fines) for the illegal protectionism laws.

Overall Ferguson believes free trade will continue, but movements for freer trade may slow unless the costs and benefits are clearly delineated.

Monday, October 04, 2004

In the past week I have had several emails, and two phone calls, from people asking about the newsletter. So in part to save time and in part to explain to all, I will make a few public comments about the newsletter.

First of all, yes it is coming out. Soon. Or so I say. It just takes too long! I estimate about 8 hours. Now if I had an extra 8 hours laying around...lol.

But even more than the time it takes to create the newsletter, is the large number of newsletters that get sent to bulk (or junk) mail accounts or blocked outright by the anti-spam software packages. For instance, I tried sending myself test newletters (to my Yahoo account) and three times in a row (even after I marked it as not spam), the test message was delivered to my bulk mail account. On top of that I have herd from professors at several schools saying that they (or the students) has stopped getting the newsletter even though they see I am still publishing it.

It is one thing to devote the hours of making a newsletter if people are going to receive it (let alone read it), but if it is not even making it to the correct mailbox, then I sort of have lost my motivation.

Hence the blog! As I mentioned in the August Newsletter, I am very excited about it! And now that I have had some time to work with it, I think it may be even better than I hoped and better in some ways than the old format (admit it, it is difficult to make time to read a 16 page newsletter!).

Thus, the newsletter (which I will try to make monthly) will be more of a recap of what has been happening on the blog, along with some other things (example important news, what I am reading, etc.).

However, the emphasis has turned more to research papers. To those of you just wanting the news, I apologize. But given that there are many news sources out there, in some ways I would be merely replicating their efforts.

If you want a daily newsletter (almost same format as mine if you select the text option), I suggest that you subscribe to the free New York Times Deal Book. They link to many stories (not all on the NY Times site) and the newsletter is VERY good! From their web site:

Saturday, October 02, 2004

The nearly annual debate as to whether developed nations should forgive the debt owed them by less developed nations has been in the news again this week. MarketPlace is one of my favorite (non music) radio shows and All Things considered each had reports on it.
NPR : The Marketplace Report: Forgiving Third World Debt

While NPR seems to be more convinced than other sources that the debt will be forgiven, all agree that there are roadblocks and problems.

So let's step back and examine them: The basic idea is that many poor nations have borrowed so much debt, that debt service (repayment of principle and interest) is preventing the nations from growing economically.

On one hand, forgiving debt will free money that could then be used to help the poor, build new infrastructure or make other improvements. But would it? Empirically it is hard to dismiss the possibility that, at least in some nations, the money be used to further leaders' lavish lifestyles.

Moreover, is it fair to forgive the debt of only a select few nations? And what about the precedent that the debt forgiveness would create: go ahead and waste the money, we won't make you repay it.

Indeed, it could be argued that one of the things that led to the US being an economic power was the hard stance that Alexander Hamilton took too force the repayment of Colonial Debt.

But of course you probably know this and are bored with it as the debate has been waged for years. But before you dismiss it as the same old same old, there is a difference this year.

What makes it different this year is that rather than being waged by Bono and crew, the call for debt forgiveness is being led by US government. Why? A large reason is that the US is pushing for forgiveness of much of Iraqi debt to help the nation recover from the war and current terrorism.

Of course, it is not so easy as if you forgive one nation, do you forgive all nations? Where do you draw the line?

As an aside, some of the discussion is just silly. For instance, when a backer of forgiveness says that the nations have paid back more than they borrowed already due to interest payments. Any student in an introductory finance course should be able to rip that argument to shreds with only a modicum of knowledge of the time value of money.

This is not a typical blog entry, but it does bring finance and business into a much better light and helps to reduce the unemployment in Iraq. I sure hope it is legit. It is almost too good to be true.

Those of you who have been subscribers for a while probably remember my editorial on how finance could help in the war against terrorism. By providing the funding necessary to improve the economies of the nations while (and this is important) opening the institutions and markets. Now of course safety is a MAJOR concern and no business would currently open operations in Iraq. But a charity is doing just that. JumpStartInternational.

To quote their website: "Our programs hope to spur employment and the generation of private businesses and public opportunity." BRAVO!

Currently, the group is doing is working to clean and rebuild after years of destruction, wars, and more recent looting and burning. Almost all of the employees are previously unemployed Iraqis.

Unfortunately, this work is dangerous (A co-founder was assassinated and many workers were injured in a bomb explosion), but getting people back working and fixing up their nation is invaluable work.

As an aside, it was interesting to hear the remaining founder Sean O'Sullivan tell how he pays about a third of what government organizations are paying for supplies---mmm, maybe incentives matter after all ;) There, finance content :)